Financial Management

Friday 9 December 2011

Time allowed
Reading and planning:
Writing:

15 minutes
3 hours

ALL FOUR questions are compulsory and MUST be attempted.

Formulae Sheet, Present Value and Annuity Tables are on
pages 6, 7 and 8.
Do NOT open this paper until instructed by the supervisor.
During reading and planning time only the question paper may
be annotated. You must NOT write in your answer booklet until
instructed by the supervisor.
This question paper must not be removed from the examination hall.

The Association of Chartered Certified Accountants

Paper F9

Fundamentals Level Skills Module

ALL FOUR questions are compulsory and MUST be attempted

1

Warden Co plans to buy a new machine. The cost of the machine, payable immediately, is $800,000 and the
machine has an expected life of five years. Additional investment in working capital of $90,000 will be required at
the start of the first year of operation. At the end of five years, the machine will be sold for scrap, with the scrap value
expected to be 5% of the initial purchase cost of the machine. The machine will not be replaced.
Production and sales from the new machine are expected to be 100,000 units per year. Each unit can be sold for
$16 per unit and will incur variable costs of $11 per unit. Incremental fixed costs arising from the operation of the
machine will be $160,000 per year.
Warden Co has an after-tax cost of capital of 11% which it uses as a discount rate in investment appraisal. The
company pays profit tax one year in arrears at an annual rate of 30% per year. Capital allowances and inflation should
be ignored.
Required:
(a) Calculate the net present value of investing in the new machine and advise whether the investment is
financially acceptable.
(7 marks)
(b) Calculate the internal rate of return of investing in the new machine and advise whether the investment is
financially acceptable.
(4 marks)
(c) (i)

Explain briefly the meaning of the term sensitivity analysis in the context of investment appraisal;
(1 mark)

(ii) Calculate the sensitivity of the investment in the new machine to a change in selling price and to a
change in discount rate, and comment on your findings.
(6 marks)
(d) Discuss the nature and causes of the problem of capital rationing in the context of investment appraisal, and
explain how this problem can be overcome in reaching the optimal investment decision for a company.
(7 marks)
(25 marks)

Extracts from the recent financial statements of Bold Co are given below.
Turnover
Cost of sales
Gross profit

$000
21,300
16,400

4,900

$000

Non-current assets
Current assets
Inventory
Trade receivables

$000
3,000

4,500
3,500

8,000

11,000

Total assets
Current liabilities
Trade payables
Overdraft

3,000
3,000

6,000

Equity
Ordinary shares
Reserves

1,000
1,000

2,000

Non-current liabilities
Bonds

3,000

11,000

A factor has offered to manage the trade receivables of Bold Co in a servicing and factor-financing agreement. The
factor expects to reduce the average trade receivables period of Bold Co from its current level to 35 days; to reduce
bad debts from 09% of turnover to 06% of turnover; and to save Bold Co $40,000 per year in administration costs.
The factor would also make an advance to Bold Co of 80% of the revised book value of trade receivables. The interest
rate on the advance would be 2% higher than the 7% that Bold Co currently pays on its overdraft. The factor would
charge a fee of 075% of turnover on a with-recourse basis, or a fee of 125% of turnover on a non-recourse basis.
Assume that there are 365 working days in each year and that all sales and supplies are on credit.
Required:
(a) Explain the meaning of the term cash operating cycle and discuss the relationship between the cash
operating cycle and the level of investment in working capital. Your answer should include a discussion of
relevant working capital policy and the nature of business operations.
(7 marks)
(b) Calculate the cash operating cycle of Bold Co. (Ignore the factors offer in this part of the question).
(4 marks)
(c) Calculate the value of the factors offer:
(i) on a with-recourse basis;
(ii) on a non-recourse basis.

(7 marks)

(d) Comment on the financial acceptability of the factors offer and discuss the possible benefits to Bold Co of
factoring its trade receivables.
(7 marks)
(25 marks)

[P.T.O.

Recent financial information relating to Close Co, a stock market listed company, is as follows.
Profit after tax (earnings)
Dividends

$m
666
400

Statement of financial position information:

$m

$m
595
125

720

Non-current assets
Current assets
Total assets
Current liabilities
Equity
Ordinary shares ($1 nominal)
Reserves

70
80
410

490

Non-current liabilities
6% Bank loan
8% Bonds ($100 nominal)

40
120

160

720

Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per year. This
is slightly less than the forecast growth rate of the profit after tax (earnings) of the company, which is 5% per year.
The finance director of Close Co thinks that, considering the risk associated with expected earnings growth, an
earnings yield of 11% per year can be used for valuation purposes.
Close Co has a cost of equity of 10% per year and a before-tax cost of debt of 7% per year. The 8% bonds will be
redeemed at nominal value in six years time. Close Co pays tax at an annual rate of 30% per year and the ex-dividend
share price of the company is $850 per share.
Required:
(a) Calculate the value of Close Co using the following methods:
(i) net asset value method;
(ii) dividend growth model;
(iii) earnings yield method.

(5 marks)

(b) Discuss the weaknesses of the dividend growth model as a way of valuing a company and its shares.
(5 marks)
(c) Calculate the weighted average after-tax cost of capital of Close Co using market values where appropriate.
(8 marks)
(d) Discuss the circumstances under which the weighted average cost of capital (WACC) can be used as a
discount rate in investment appraisal. Briefly indicate alternative approaches that could be adopted when
using the WACC is not appropriate.
(7 marks)
(25 marks)

Bar Co is a stock exchange listed company that is concerned by its current level of debt finance. It plans to make a
rights issue and to use the funds raised to pay off some of its debt. The rights issue will be at a 20% discount to its
current ex-dividend share price of $750 per share and Bar Co plans to raise $90 million. Bar Co believes that paying
off some of its debt will not affect its price/earnings ratio, which is expected to remain constant.
Income statement information
Turnover
Cost of sales
Profit before interest and tax
Interest
Profit before tax
Tax
Profit after tax

$m
472
423

49
10

39
12

27

Statement of financial position information

$m
Equity
Ordinary shares ($1 nominal)
Reserves
Long-term liabilities
8% bonds ($100 nominal)

60
80

140
125

265

The 8% bonds are currently trading at $11250 per $100 bond and bondholders have agreed that they will allow
Bar Co to buy back the bonds at this market value. Bar Co pays tax at a rate of 30% per year.
Required:
(a) Calculate the theoretical ex rights price per share of Bar Co following the rights issue.

(3 marks)

(b) Calculate and discuss whether using the cash raised by the rights issue to buy back bonds is likely to be
financially acceptable to the shareholders of Bar Co, commenting in your answer on the belief that the
current price/earnings ratio will remain constant.
(7 marks)
(c) Calculate and discuss the effect of using the cash raised by the rights issue to buy back bonds on the
financial risk of Bar Co, as measured by its interest coverage ratio and its book value debt to equity ratio.
(4 marks)
(d) Compare and contrast the financial objectives of a stock exchange listed company such as Bar Co and the
financial objectives of a not-for-profit organisation such as a large charity.
(11 marks)
(25 marks)

[P.T.O.

Formulae Sheet
Economic order quantity
2C0D

Ch

MillerOrr Model
Return point = Lower limit + (

1
spread)
3
1

3 transaction cost variance of cash flows 3

Spread = 3 4

interest rate

The Capital Asset Pricing Model

(( ) )

()

E ri = Rf + i E rm Rf

The asset beta formula

Vd 1 T
Ve

a =
e +
d

V
+
V
T
V
V
1

+
1

T
d
d
e
e

))

))

The Growth Model

Po =

D0 1 + g

(r

Gordons growth approximation

g = bre
The weighted average cost of capital
V

e
d
ke +
k 1 T
WACC =
Ve + Vd
Ve + Vd d

The Fisher formula

(1 + i) = (1 + r ) (1 + h)
Purchasing power parity and interest rate parity

S1 = S0

(1 + h )
(1 + h )
c

F0 = S0

(1 + i )
(1 + i )
c

Present Value Table

Present value of 1 i.e. (1 + r)n
Where

r = discount rate
n = number of periods until payment
Discount rate (r)

Periods
(n)

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4

0990
)
0980
) 
0971
)
0961
)
0951
)


0980
) 
0961
)
0942
) 
0924
)
0906
)

0971
)
0943
) 
0915
)

0888
)
0863
) 

0962
)
0925
)

0889
) 
0855
)

0822
) 

0952
)

0907
)
0864
) 
0823
) 
0784
)

0943
) 
0890
) 
0840
) 
0792
)
0747
) 

0935
)

0873
) 
0816
) 
0763
)
0713
)

0926
)
0857
)

0794
)
0735
)

0681
) 

0917
)
0842
) 
0772
)
0708
)
0650
)


0909
)
0826
) 
0751
)

0683
) 
0621
)

1
2
3
4

6
7
8
9
10


0942
) 
0933
)
0923
)
0941
)
0905
)

0888
)
0871
) 
0853
)

0837
) 
0820
) 

0837
) 
0813
) 
0789
) 
0766
)
0744
)

0790
)
0760
)
0731
)
0703
)
0676
)

0746
) 
0711
)
0677
)
0645
)

0614
)

0705
)

0665
)

0627
)
0592
)

0558
)

0666
)
0623
)
0582
)

0544
)

0508
)


0630
)
0583
)

0540
)

0500
)

0463
) 

0596
)

0547
)

0502
)

0460
) 
0422
) 

0564
)

0513
)

0467
) 
0424
) 
0386
) 

6
7
8
9
10


11

12

13

14

15


0896
) 
0887
) 
0879
) 
0870
) 
0861
) 

0804
) 
0788
)
0773
)
0758
)

0743
) 

0722
)
0701
)
0681
) 
0661
)
0642
) 

0650
)

0625
)

0601
)
0577
)

0555
)

0585
)

0557
)


0530
)

0505
)


0481
) 

0527
)

0497
) 
0469
) 
0442
) 
0417
) 

0475
) 

0444
)
0415
) 

0388
)
0362
)

0429
) 
0397
)
0368
)
0340
) 
0315
)

0388
)
0356
)

0326
)
0299
)
0275
)

0305
)

0319
)
0290
)
0263
)
0239
)

11

12

13

14

15


(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4

0901
)
0812
) 
0731
)
0659
)

0593
)


0893
) 
0797
)
0712
)
0636
)
0567
)


0885
)

0783
) 
0693
)
0613
)
0543
)


0877
) 
0769
)
0675
)

0592
)

0519
)


0870
) 
0756
)

0658
)

0572
)

0497
) 

0862
) 
0743
) 
0641
) 
0552
)


0476
) 

0855
)

0731
)
0624
)
0534
)

0456
)


0847
) 
0718
)
0609
)
0516
)

0437
) 

0840
) 
0706
)
0593
)

0499
) 
0419
) 

0833
) 
0694
)
0579
)

0482
) 
0402
) 

1
2
3
4

6
7
8
9
10


0535
)


0482
) 
0434
) 
0391
)
0352
)


0507
)

0452
)

0404
) 
0361
)
0322
)

0480
) 
0425
) 

0376
)
0333
)
0295
)

0456
)

0400
) 
0351
)

0308
)
0270
)

0432
) 
0376
)
0327
)
0284
)
0247
) 

0410
) 
0354
)

0305
)

0263
)
0227
)

0390
)
0333
)
0285
)

0243
) 
0208
)

0370
)
0314
)
0266
)
0225
)

0191
)

0352
)

0296
)
0249
) 
0209
)
0176
)

0335
)

0279
)
0233
)
0194
)
0162
)

6
7
8
9
10


11

12

13

14

15


0317
)
0286
) 
0258
)

0232
)
0209
)

0287
) 
0257
)

0229
)
0205
)

0183
) 

0261
)
0231
)
0204
)
0181
) 
0160
)

0237
)
0208
)
0182
) 
0160
)
0140
) 

0215
)

0187
) 
0163
)
0141
) 
0123
)

0195
)

0168
)
0145
)

0125
)

0108
)

0178
)
0152
)

0130
)
0111
)
0095
)

0162
)
0137
)
0116
)
0099
)
0084
)

0148
)
0124
)
0104
)
0088
)
0074
)

0135
)

0112
)
0093
)
0078
)
0065
)

11

12

13

14

15


[P.T.O.

Annuity Table
(1 + r)n
Present value of an annuity of 1 i.e. 1
r
Where

r = discount rate
n = number of periods
Discount rate (r)

Periods
(n)

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0990
1970
2941
3902
4853

0980
1942
2884
3808
4713

0971
1913
2829
3717
4580

0962
1886
2775
3630
4452

0952
1859
2723
3546
4329

0943
1833
2673
3465
4212

0935
1808
2624
3387
4100

0926
1783
2577
3312
3993

0917
1759
2531
3240
3890

0909
1736
2487
3170
3791

1
2
3
4
5

6
7
8
9
10

5795
6728
7652
8566
9471

5601
6472
7325
8162
8983

5417
6230
7020
7786
8530

5242
6002
6733
7435
8111

5076
5786
6463
7108
7722

4917
5582
6210
6802
7360

4767
5389
5971
6515
7024

4623
5206
5747
6247
6710

4486
5033
5535
5995
6418

4355
4868
5335
5759
6145

6
7
8
9
10

11
12
13
14
15

1037
1126
1213
1300
1387

9787
1058
1135
1211
1285

9253
9954
1063
1130
1194

8760
9385
9986
1056
1112

8306
8863
9394
9899
1038

7887
8384
8853
9295
9712

7499
7943
8358
8745
9108

7139
7536
7904
8244
8559

6805
7161
7487
7786
8061

6495
6814
7103
7367
7606

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0901
1713
2444
3102
3696

0893
1690
2402
3037
3605

0885
1668
2361
2974
3517

0877
1647
2322
2914
3433

0870
1626
2283
2855
3352

0862
1605
2246
2798
3274

0855
1585
2210
2743
3199

0847
1566
2174
2690
3127

0840
1547
2140
2639
3058

0833
1528
2106
2589
2991

1
2
3
4
5

6
7
8
9
10

4231
4712
5146
5537
5889

4111
4564
4968
5328
5650

3998
4423
4799
5132
5426

3889
4288
4639
4946
5216

3784
4160
4487
4772
5019

3685
4039
4344
4607
4833

3589
3922
4207
4451
4659

3498
3812
4078
4303
4494

3410
3706
3954
4163
4339

3326
3605
3837
4031
4192

6
7
8
9
10

11
12
13
14
15

6207
6492
6750
6982
7191

5938
6194
6424
6628
6811

5687
5918
6122
6302
6462

5453
5660
5842
6002
6142

5234
5421
5583
5724
5847

5029
5197
5342
5468
5575

4836
4988
5118
5229
5324

4656
4793
4910
5008
5092

4486
4611
4715
4802
4876

4327
4439
4533
4611
4675

11
12
13
14
15

End of Question Paper